Earth to Ben Bernanke

Chairman Bernanke Should Listen to Professor Bernanke

When the financial crisis struck in 2008, many economists took comfort in at least one aspect of the situation: the best possible person, Ben Bernanke, was in place as chairman of the Federal Reserve.

Bernanke was and is a fine economist. More than that, before joining the Fed, he wrote extensively, in academic studies of both the Great Depression and modern Japan, about the exact problems he would confront at the end of 2008. He argued forcefully for an aggressive response, castigating the Bank of Japan, the Fed’s counterpart, for its passivity. Presumably, the Fed under his leadership would be different.

Instead, while the Fed went to great lengths to rescue the financial system, it has done far less to rescue workers. The U.S. economy remains deeply depressed, with long-term unemployment in particular still disastrously high, a point Bernanke himself has recently emphasized. Yet the Fed isn’t taking strong action to rectify the situation.

The Bernanke Conundrum — the divergence between what Professor Bernanke advocated and what Chairman Bernanke has actually done — can be reconciled in a few possible ways. Maybe Professor Bernanke was wrong, and there’s nothing more a policy maker in this situation can do. Maybe politics are the impediment, and Chairman Bernanke has been forced to hide his inner professor. Or maybe the onetime academic has been assimilated by the Fed Borg and turned into a conventional central banker. Whichever account you prefer, however, the fact is that the Fed isn’t doing the job many economists expected it to do, and a result is mass suffering for American workers.

The Federal Reserve has a dual mandate: price stability and maximum employment. It normally tries to meet these goals by moving short-term interest rates, which it can do by adding to or subtracting from bank reserves. If the economy is weak and inflation is low, the Fed cuts rates; this makes borrowing attractive, stimulates private spending and, if all goes well, leads to economic recovery. If the economy is strong and inflation is a threat, the Fed raises rates; this discourages borrowing and spending, and the economy cools off.

Photo

Bernanke during a hearing on the European debt crisis on Capitol Hill in March.Credit
Luke Sharrett for The New York Times

Right now, the Fed believes that it’s facing a weak economy and subdued inflation, a situation in which it would ordinarily cut interest rates. The problem is that rates can’t be cut further. When the recession began in 2007, the Fed started slashing short-term interest rates until November 2008, when they bottomed out near zero, where they remain to this day. And that was as far as the Fed could go, because (some narrow technical exceptions aside) interest rates can’t go lower. Investors won’t buy bonds if they can get a better return simply by putting a bunch of $100 bills in a safe. In other words, the Fed hit what’s known in economic jargon as the zero lower bound (or, alternatively, became stuck in a liquidity trap). The tool the Fed usually fights recessions with had reached the limits of its usefulness.

That doesn’t mean the Fed was out of options. Not according to the work of a number of economists, anyway, among them a prominent Princeton professor by the name of Ben Bernanke. As noted above, Bernanke was among the economists who took notice, back in the 1990s, of the troubles afflicting Japan — a huge real estate bubble that left behind a legacy of high private-sector debt when it burst and a central bank up against the zero lower bound.

The woes confronting the United States today aren’t identical to those faced by Japan. For one thing, Japanese inflation wasn’t just low; by the end of the 1990s, Japan was actually suffering chronic deflation. For another, Japan’s slump was never as terrible as ours; unemployment, in particular, never became the scourge it has become here. Still, Japan provided an example of how an advanced modern economy could seemingly be caught in an economic trap.

In a hard-hitting 2000 paper titled “Japanese Monetary Policy: A Case of Self-Induced Paralysis?” Bernanke declared that “far from being powerless, the Bank of Japan could achieve a great deal if it were willing to abandon its excessive caution and its defensive response to criticism.” He proceeded to lay out a number of actions the Bank of Japan could take. And he called on Japanese policy makers to act like F.D.R. and do whatever it took: “Japan is not in a Great Depression by any means, but its economy has operated below potential for nearly a decade. Nor is it by any means clear that recovery is imminent. Policy options exist that could greatly reduce these losses. Why isn’t more happening? To this outsider, at least, Japanese monetary policy seems paralyzed, with a paralysis that is largely self-induced. Most striking is the apparent unwillingness of the monetary authorities to experiment, to try anything that isn’t absolutely guaranteed to work. Perhaps it’s time for some Rooseveltian resolve in Japan.”

Bernanke had some specific proposals that could serve as advice for the Fed today. One set of options would have it take a larger role in financial markets. Short-term interest rates may be zero, unable to go lower, but longer-term rates aren’t. So the Fed, which typically buys only short-term U.S. government debt, could expand its portfolio, buying long-term government debt, bonds backed by home mortgages and so on, in an effort to drive down the interest rates on these assets. This is the strategy that has come to be known, unhelpfully, as quantitative easing.

Another set of options involves trying to change expectations about future Fed policy. Right now, investors believe that the economy will eventually recover enough for the Fed to start raising rates again. Such expectations about future Fed plans, in turn, can have an important impact on the economy right now. In particular, beliefs about how long the Fed will wait before raising rates can have a major impact on expectations of future inflation. At the moment, investors assume that the Fed will raise rates enough to keep inflation from rising much above 2 percent. If the Fed were to raise its target for inflation — and if investors believed in the new target — expected inflation over the medium term, say the next 10 years, would be higher. Many economists, ranging from the chief economist of the International Monetary Fund to one of Mitt Romney’s top economic advisers, have argued, as I have, that higher expected inflation would aid an economy up against the zero lower bound, because it would help persuade investors and businesses alike that sitting on cash is a bad idea. Bernanke endorsed the idea in his “Paralysis” paper, suggesting that the Bank of Japan declare “a target in the 3-to-4-percent range for inflation, to be maintained for a number of years.”

So which of these steps has the Fed taken lately? Well, it has bought more than $2 trillion worth of long-term government debt and bonds of government-backed housing agencies. That sounds like a lot, but it’s much less than most analysts think necessary to jump-start economic recovery. The Fed has also tried to influence market expectations about future policy, but only for the fairly near term, declaring that it doesn’t expect to raise short-term rates until late 2014. What’s more, Bernanke has ruled out more ambitious policies. In 2010, for example, he dismissed the notion of a higher inflation target for the United States, arguing that it would undermine confidence and the Fed’s “hard-won inflation credibility.”

In short, Chairman Bernanke’s Fed has been much more passive than Professor Bernanke’s writings would have led us to expect.

Can the Fed Do No More?

Some economists and Fed officials believe that the Fed has already done all it can or should — that, in particular, high unemployment is structural, that it can’t be brought down simply by getting people to increase spending. They also warn that any further efforts by the Fed to boost the economy would simply drive up inflation instead. This is, however, a minority view both among economists and at the Fed.

Most stories about structural unemployment stress a perceived mismatch between the work force and employment opportunities: workers, so the story goes, either have the wrong skills or are in the wrong place. But as Bernanke pointed out in a recent speech, employment looks bad across the board: “The fact that labor demand appears weak in most industries and locations is suggestive of a general shortfall of aggregate demand rather than a worsening mismatch of skills and jobs.” As a result, he declared, the data “do not support the view that structural factors are a major cause of the increase in unemployment during the most recent recession.”

What about inflation? So-called headline inflation, a k a the Consumer Price Index, has fluctuated wildly — deflation during the worst of the recession, annualized inflation hitting a peak of almost 4 percent last September. These big swings are, however, driven mainly by fluctuations in the prices of raw materials, which Fed officials consider poor indicators of underlying inflationary pressures. They prefer, instead, to focus on measures like core inflation, which excludes volatile energy and food prices and which has remained fairly quiescent.

The Fed is right in this. Last year, many conservatives seized on rising headline inflation — driven mainly by increasing gasoline prices — as evidence of a looming inflation tsunami. Representative Paul Ryan, the Wisconsin Republican, for example, pointed to rising prices of raw materials and said ominously, “There is nothing more insidious that a country can do to its citizens than debase its currency.” Fed officials, however, steadfastly predicted that the inflation surge would soon ebb, and it did.

So the Fed doesn’t think there are good reasons for high unemployment and isn’t worried about inflation. Indeed, the minutes from the January meeting of the Federal Open Market Committee, which sets monetary policy, revealed that a majority of members expected an eventual fall in unemployment to below 6 percent, with inflation remaining low.

Think about what this means in terms of the dual mandate. The Fed is supposed to pump up the economy when it’s running too cold, with unemployment high and inflation low. That’s where we are right now, in the Fed’s own estimation. Yet the most recent minutes, from March, show Fed officials unwilling to take any further action to boost the economy.

Why won’t the Fed do more?

Political Bullying

When Fed critics interpreted a brief escalation in raw-material prices as evidence of out-of-control inflation last year, it was unusual only because for once the critics had some actual inflation to talk about. Since 2008, the Fed has faced constant attacks over its supposed inflationary actions, whether or not the actual data indicate the existence of runaway inflation. Some attacks have even bordered on menace, most famously Rick Perry’s warning that Bernanke would be treated “pretty ugly” if he visited Texas.

The effect must be somewhat intimidating. Recently N. Gregory Mankiw of Harvard University — an adviser to Mitt Romney who himself briefly advocated raising the inflation target but went quiet after receiving intense criticism — put it succinctly: “If Chairman Bernanke ever suggested increasing inflation to, say, 4 percent, he would quickly return to being Professor Bernanke.”

Maybe, then, Bernanke still wants higher inflation and other unconventional policies but knows that there’s no point in pursuing or even advocating them. But there are two problems with this supposition. First, that’s not the way the Fed is supposed to work. It’s meant to be insulated from political pressure — so why would people so calmly accept the notion that it could be pressed to avoid doing what it thinks it should do? Second, Bernanke has gone out of his way to insist that his current position reflects an economic judgment, not political compromise — that it’s all about preserving that “hard-won inflation credibility.”

I suspect that the old Bernanke would have scoffed. He would have pointed out that the Fed could still keep inflation within bounds — that 4 percent inflation (which is what we actually had during the late years of the Reagan administration) need be no more unsettling than 2 percent inflation. He would also, I suspect, have argued that the risks of losing credibility pale beside the risks of inaction. Bear in mind, whenever someone invokes the specter of a return to ’70s-style stagflation, when the economy is weak and inflation is high — a greatly overrated risk — that what we are going through now is much, much worse than anything that happened in the ’70s. It takes a certain mind-set to worry more about a hypothetical loss of confidence than about the clear and present suffering of the unemployed — the mind-set, one might say, of a conventional central banker.

Recently Laurence Ball of Johns Hopkins University made waves among monetary economists by looking through Fed minutes to determine how and when Ben Bernanke’s views changed. According to Ball, Bernanke’s big retreat from F.D.R.-like resolve happened way back in 2003, less than a year after he arrived at the Fed. That month, a Fed staff report rejected many of the ideas Bernanke previously supported — and ever since, Bernanke has spoken only of limited responses to the problem of the zero lower bound. What’s puzzling about this apparent conversion is the fact that while Bernanke may have been a newbie at the Fed, he was a towering figure in his field. Why should he have taken his cues from a staff report?

Ball emphasizes both the pressures of groupthink and Bernanke’s shy personality. Without necessarily disagreeing, I’d point to a crucial difference between the policies Bernanke advocated in his pre-Fed days and the ones he has supported since 2003. His Fed-era policies aren’t simply less ambitious than those of his academic era; just as important, Chairman Bernanke’s policy menu, unlike Professor Bernanke’s proposals, has been set up so that the Fed can’t be blamed for failure.

Suppose, for example, that the Fed announces a higher inflation target. It might not work: markets might not consider the Fed’s proclamations credible and believe instead that no matter what the Fed says now, it will return to its traditional focus on price stability. So an attempt to raise expected inflation could lead to an embarrassing failure. When buying government bonds, on the other hand, the Fed can always claim that the policy worked, even if the economy does poorly, because it can insist that things would have been even worse without its actions. So by retreating to a narrow definition of the Fed’s role, Bernanke has also adopted a position that is much more comfortable for the Fed as an institution.

Back in 2000, Professor Bernanke warned against exactly this kind of retreat, harshly criticizing the Bank of Japan’s unwillingness to “try anything that isn’t absolutely guaranteed to work.” But within a year of his arrival at the Fed, he seemed to have been assimilated by the Fed Borg, like Capt. Jean-Luc Picard in a famous “Star Trek” episode, converted into a half-robot servant of a hive-mind.

Bernanke may have pulled back from his earlier activism years ago, but given the scale of our economic catastrophe, he might well have returned to his earlier views if the political climate hadn’t been so hostile. So I wouldn’t fully discount the importance of right-wing bullying. As for his insistence that it’s not about politics — could he really get away with saying, or even hinting, that pressure from the likes of Paul Ryan is keeping him from pursuing full employment?

My best guess is that the disappointing response of the Bernanke Fed represents the effects of both bullies and the Borg, a combination of political intimidation and the desire to make life easy for the Fed as an institution. Whatever the mix of these motives, the result is clear: faced with an economy still in desperate need of help, the Fed is unwilling to provide that help. And that, unfortunately, makes the Fed part of a broader problem.

Consider, if you will, the current state of our nation. Despite hints of economic progress, we’re still in the midst of an immense disaster, in which unemployment and underemployment are devastating millions of American lives. And none of this need be happening! There has been no plague of locusts; we have not lost our technological know-how. Americans should be richer, not poorer, than they were five years ago. Yet economic policy across the board has become almost passive, has essentially accepted this disaster instead of trying to end it.

The Fed under Bernanke is by no means the worst sinner in this failure of intellect and will, and you can argue that Ben Bernanke has done a better job than anyone else who might have held his position. Yet the fact is, he has not done remotely enough. The Fed, under its eminent chairman, was supposed to be an important part of the solution to mass unemployment. That isn’t happening.

This article has been adapted from “End This Depression Now!” by Paul Krugman, to be published by W. W. Norton & Company this month.

Krugman is a Times columnist and winner of the 2008 Nobel Prize in economics.

A version of this article appears in print on April 29, 2012, on page MM18 of the Sunday Magazine with the headline: Earth to Ben Bernanke. Today's Paper|Subscribe